ikkyu2 (99.07)

CAPS strategy: more thoughts

9

I'm going to talk about the different strategies behind successful long-term outperform and underperform picks. This is probably not going to be revelatory to most readers of my CAPS blog, but occasionally I may point folks towards this entry to avoid having to explain these things over and over again.

First of all, for these strategies to work, the picks must be successful - a stock picked to outperform must actually outperform, and a stock picked to underperform must actually underperform over the time period in question. This post is not about how to identify such stocks; it assumes you have some in hand and you want to know how to manage them best in CAPS.

The strategy is simply stated: Always end successful underperform picks. Never end successful outperform picks.

Why?

Let's talk about underperform picks first. We'll take a hypothetical stock, XYZ, with a market cap of $800 million and a stock price of $80. You know XYZ is going to underperform over the next while, so you put the red thumb on it. Let's say in month #1 it drops by 50%, to $40. (For the sake of ease of analysis, let's say the S+P doesn't move during any of the periods under study, and there are no dividends.) You now have an underperform pick on XYZ, starting with a price of $80, dropping to a price of $40, with a net score of +50 points.

Now let's assume that XYZ is not done dropping, and that in the next month XYZ will drop from $40 to $20. You have two choices at the end of month #1. You could leave your outperform pick to ride, in which case at the end of month two you'll end up with one pick with starting price $80, end price $20, net score +75 points. Or you could end the pick and immediately repick XYZ to underperform. Assuming XYZ stays at $40 during the 40 trading minutes you're blacked out, at the end of month two, you'll have two picks, one 80/40/+50, and another one 40/20/+50. Ending the pick and re-picking gives you an extra +25 score points - for making the same pick you were going to make anyway. But there is a hidden advantage to this as well. Instead of one accurate pick, you're credited with two accurate picks, even though you've done nothing better, more useful or more interesting than the guy who let his single pick ride.

CAPS puts some limitations on this. Your pick has to have a minimum score of +5.00 when it ends, or else you won't get the extra accuracy point. You also can't re-pick a stock to underperform once it's fallen under the $100 million market cap / $1.50 share price limit. Conclusion: IF you want the highest CAPS rating, and IF your underperform pick shows a score greater than 5.0 on a stock with marketcap > $100 million and share price > $1.50, you have to end your pick and re-pick it. If you don't, you're losing ground, compared to others who might pick the same stock over the same period, be exposed to the same risks, and yet gain many more score and accuracy points than you did.

Outperform picks are easier to understand. Let's consider ABC Corp, with a $100 million market cap and a share price of $10 on August 6, 2007. It's a fast growing small cap stock, and you pick it to Outperform as of that date. In fact, it's the AT&T or Home Depot or Altria or Super-Google of the next ten years. You leave the pick going and never touch it.

Ten years from the day you pick it, ABC Corp is a Dow Jones component, a true blue chip stock, with a $100 billion market cap. It's gone up 1000x - that is, 100,000%, far outperforming the S+P 500. (Many, many splits have kept the share price below 100, just like the glory days of Home Depot.) On August 6, 2017, you have an active pick with a score of +100,000.

You think it's going to keep outperforming. Now check this out. On August 7th 2017, ABC corp goes up 1%. That means it gains $1 billion in market cap. That's ten times the entire market cap of the stock as of the day you picked it. That means that your pick gains 1,000 points on a price movement of 1%. If the stock doubles in value in 2018, your pick gains - wait for it - ANOTHER 100,000 points.

However, what about the guy who picked ABC to outperform on Aug 7 2017? He gets 1 point for the 1% price move. If it doubles he gets 100 points. He can *never* catch up.

I was adamant that I wasn't going to implement these strategies, but that's dumb. The object of playing a game is to win the game. So I've changed my mind. Unfortunately I'm not very good at it just yet - I stupidly ended a pick on GTW, whose share price has dipped well below the $1.50 minimum required to re-pick it; and I ended my NILE outperform pick, which I'm going to regret if I'm still playing CAPS in 2017.

Right now a lot of flack is directed at the top 10 list, who got there by using my underperform method to inflate their accuracy scores on the housing and credit stocks. That's great for them. But in 2017, no one using this method is going to be anywhere near the top of the CAPS list. In fact, that list will be quite dull. One stock that had around a $100 million market cap in mid 2006 is going to have pulled a Home Depot or an Altria - I don't know which stock it is, maybe you do - and the guy with the score leader badge for picking that stock to outperform is going to sit at the top of the score list and he will never be dethroned. (He'll probably have exactly 6 other accurate outperform picks for an accuracy of 100%, keeping him in the game, so no one will be able to beat him by out-accurizing him.)

The described strategies are the way the game's incentivized, and so over the long term winners *will* play by these rules. Period. These incentives go against the CAPS authors' stated reasons for having CAPS exist - namely, to create a universe of accurate stock rankings - and so I expect that eventually the creators of the game will either catch on and change the incentives, or more likely they and the players will abandon it out of boredom.

Outperform picks are easier to understand. Let's consider ABC Corp, with a $100 million market cap and a share price of $10 on August 6, 2007. It's a fast growing small cap stock, and you pick it to Outperform as of that date. In fact, it's the AT&T or Home Depot or Altria or Super-Google of the next ten years. You leave the pick going and never touch it.

Ten years from the day you pick it, ABC Corp is a Dow Jones component, a true blue chip stock, with a $100 billion market cap. It's gone up 1000x - that is, 100,000%, far outperforming the S+P 500. (Many, many splits have kept the share price below 100, just like the glory days of Home Depot.) On August 6, 2017, you have an active pick with a score of +100,000.

You think it's going to keep outperforming. Now check this out. On August 7th 2017, ABC corp goes up 1%. That means it gains $1 billion in market cap. That's ten times the entire market cap of the stock as of the day you picked it. That means that your pick gains 1,000 points on a price movement of 1%. If the stock doubles in value in 2018, your pick gains - wait for it - ANOTHER 100,000 points.

Intersting post. We are being compared against the S&P 500 at the time we picked ABC corp. What has the S&P done during all this time? What would happen to your score on Aug 17th if ABC corp goes up 1% but the S&P goes up 2%? Would that be a 500 point hit?

Devoish, it becomes mathematically more complicated to consider the actions of the S+P, but it doesn't really change anything fundamental about the way the numbers work. The idea is that your picks are scored against a baseline. For the purpose of making the math easy to understand, I chose a baseline of zero - no movement in the S+P. But as it happens the baseline isn't zero - it's a moving target, which is the S+P.

If the S+P moves over the time period in question, it won't move as much as the successful pick does, or it will move in the opposite direction. (Otherwise the pick isn't "successful," by the very definition of a successful CAPS pick.)

Over long periods of time with regard to truly outperforming stocks, the "magic of compounding" will erase the contribution of the S+P, even if it's strong.

Let's try some simple math. The S+P goes up 10% per year for 20 years - a strong but historically reasonable performance. ABC corp (which we defined as the best performing stock of the period) goes up 25% per year for 20 years. At the end of 20 years, the S+P has gone up 572%. ABC corp has gone up 3733%. That leaves you with a pick worth +3161 pts. If the S+P hadn't moved, the pick would be worth +3733 pts. In this situation, over time ABC corporation "runs away" from the S+P; the S+P's contribution to the pick's score becomes minimal.

Here's something else that's fun to consider: how much can an underperform pick on one stock actually score? The CAPS help FAQ suggests that you're limited to 100 pts. But that's not true! According to my method, you can score much more than that. Believe it or not, the number of points you can score from a stock that goes bankrupt depend on the stock's initial market cap when you made the pick. (Or else the share price; if it goes below $1.50 you're done).

The actual formula involves logarithms and is left as an exercise for the student. And I hope that turns these darn italics off.

The strategy is simply stated: Always end successful underperform picks. Never end successful outperform picks.

While I understand this, and it does have a good deal of merit, this isn't necessarily true.

Take an underperform pick that does exactly what its name implies, undperperforms the S&P (but doesn't actually drop in price, simply increases in price at a slower rate than does the S&P). Ending and repicking a stock in this situation will actually result in fewer, not more score points.

I agree with your premise here as a general rule, but as with all general rules, there are exceptions.

If you decide to short stocks you have to do a lot of foot work. To be efficient, you have to constantly end and repick.

Shorting a stock all the way to zero, although it may sound vindicating, is not an efficient way to make money (you are limited to a maximum 100% return).

Because shorting does not have the automatic compounding effect that goes with "going long", you have to compensate for that by constantly re-entering your pick. Now in real life there's slippage associated with that, which is a drag.

Going long is so much more relaxing - you only have to click once and you're on your way to your 1000% return (if you picked the right stock).